See
also:General Index of all guest columns written by Dennis C. Butler,
CFA

OCTOBER
2015

T

hat old Wall Street adage,
"Sell in May and go away," has proven to be of some value
this year. From its level of 2,108.29 on May 1, the S&P 500 equity index
declined by 8.9% to 1,920.03 at the end of September. The U.S. stock market,
having become increasingly hesitant as July wore on into August, fell
precipitously, if briefly, on August 24, when the Dow Jones Industrial
Average lost 1000 points during the course of the trading session, making
for an exciting day in what had otherwise been a rather uneventful year for
equities. The averages subsequently recovered some of their poise, if not
their previous highs, and ended the third quarter with modest losses for the
year so far..

As a result
of how dull the year had been prior to the August fireworks, the financial
commentariat's reaction to the events was as furious as the market action.
Showing the media's bias, headlines treated every 1% decline as a

"plunge,"
while "risk on"
advances were cheered. New scapegoats were trotted out to
blame for the return of "volatility"
to the markets, with "risk parity"
 the
latest investment fad — among them (risk parity involves the use of borrowed
money to enhance the returns of certain assets, a strategy that often
backfires when the going gets tough). Some also pointed fingers at so-called
"passive"
institutional investors, such as index funds, that buy securities without
discriminating between what is attractive and what is not. These discussions
at least made the summer entertaining, even if it was not profitable for
traders..

Calmer and
wiser observers pointed out, however, that the market's gyrations were not
exceptional. After all, the broad market indexes fell by only about eight
percent at the lowest point. Historically, declines of 20% occur about
one-tenth of the time, so the summer

"rout"
was nothing major from that
perspective. The
Financial Times,
in keeping with its reputation for being a reliable source of cool reason,
observed that the real market anomaly of 2015 took place in the February to
August period when price fluctuations (as reflected in the S&P 500) were
confined to a narrow range of only 4%. Not since 1926 could such an extended
period of tranquility be found — despite currency swings, fears over China and
Greece, and uncertainty about the U.S. Federal Reserve's intentions with
respect to its monetary policies. It was worth noting, the
FT continued, that prior periods
of unusually subdued markets tended to presage significant price declines.
So far, however, the third quarter's slump, and corresponding jump in
volatility, represent little more than a return to more normal market
behavior..

Almost
overlooked during the excitement were reports that certain well-known
investors quietly bought stocks at lower prices and disregarded all of the
kerfuffle. This prompts us to suggest a new adage (with apologies to Mark
Twain, who once commented on the folly of speculating in stocks):
October. This is one of the peculiarly good months to ignore Wall Street
in. The others are July, January, September, April, November, May, March,
June, December, August, and February.

Although
the squawking classes talked as though a major stock market disaster had
taken place, figures for the major indexes indicate that it didn't. Prices
did decline year-to-date through September, but only in the 5-7% range
(including dividends). The NASDAQ index, home to many of the volatile
technology-related issues, declined just 2.5% (not including dividends).
Nevertheless, 2015 has been a choppy year for the stock market. Underlying
weakness throughout the broad universe of issues has not (until recently, at
least) been fully reflected in the readings of the popular market
barometers, a fact that undoubtedly puzzles many individuals when they find
that their own investment results come up short in comparison. Curiously,
this phenomenon has also occurred in the past at market peaks, although the
recent experience is nowhere near the extremes seen at prior speculative
zeniths, such as in 1999, for example.

Concerns
about the risks of high stock valuations have been growing, and given the
market's sharp rise since 2009, there is definitely good reason. Various
valuation ratios are at the upper end of their ranges. Longer-term measures
(e.g. the "CAPE" ratio — based on average earnings over ten-year periods) also
tend to support the claim that equities are richly valued (even dangerously
over-valued, according to CAPE). Such indicators do not have much predictive
power in the short run, however, and whether they signal sharp market
declines to come, as many fear, is a matter of speculation. What they do
strongly suggest is that longer-term returns from equity investments will
likely be mediocre on average from these levels (beware, index fund buyers).
The fact that it is currently very difficult to find attractive
opportunities additionally indicates rich valuations and poor prospects for
good results.

Nevertheless, the frothy conditions that typically accompany stock bubbles
seem absent at present (notwithstanding the fact that a few industry
sectors, such as biotech, have attracted intense interest). While difficult,
it is still possible to find the rare attractive situation.As we have often noted, the real excitement for investors will come
when bond market bubbles start to deflate and wreak havoc on over-extended
borrowers and their incautious lenders. An omen of things to come, perhaps:
a few bond indexes, including those for long-term corporate issues and
"high-yield" bonds, are already showing negative returns year-to-date.

Discontinuity

The
traditional view of investing held that securities should be purchased at a
discount to their true worth or "intrinsic value."  Modern financial theory,
on the other hand, maintains that markets are "efficient," meaning that
security prices reflect, in a rational manner, all information that might be
relevant to determining an issuer's worth. If the latter assertion were, in
fact, correct, then how would investing as traditionally conceived be
possible? How could discounts ever appear when thousands of observers,
analysts, and market participants are constantly digesting every bit of
data, all contributing in real time to the price discovery process? A cynic
might respond that an assumption of market efficiency is required in order
for the statistics underlying modern financial theory to work (we admit to
sympathizing with this view). The fact remains, however, that markets are
usually quite good at quickly responding to information flow and adjusting
prices accordingly. Hence, it is normally very difficult to find worthwhile
discounts — ones that persist long enough for the slow-speed trader to take
advantage of, and of a sufficient depth to attract the traditional
investor's interest. Nevertheless, discounts do appear from time to time,
and for reasons that are rooted in the nature of financial markets, as
opposed to financial theory.

Most of the time the community of investors and their enablers (brokers,
analysts, bankers, etc.) operate within a world of efficiency and rough
"equilibrium," to employ a term dear to economists.
Decision-makers allocate capital, analysts analyze, and bankers promote
securities, all relying on an assumption that a recognizable sort of
normalcy will prevail in the future, permitting growth and earnings
projections to be met (roughly), businesses to dive or thrive, and demand
for new products to appear. In other words, the present will more or less
continue into the future and impact it in predictable ways. Note that this
stance is to a very large extent backward-looking. As the military
prepares "for the last war,"
according to the common expression, Wall Street looks forward to the last
financial crisis. Hence, as a result of the 2008-09 experience, in this
world even "black swan"
events (a term which became popular during the crisis, it
refers to the out-of-left-field, unexpected, and unpredictable occurrences
that upend the normal state of affairs) have become "normal"
in the sense that they are identified, discussed, and warned against.
Investing, for the most part, becomes a routine search for "growth" or some more or less
temporary business advantage.

As a great
investor once observed, markets change, but human nature stays the same. So
when the world acts in unexpected ways, things get truly interesting. Whether it is due to the appalling collapse of the U.S. real estate finance
system in 2008, unforeseen consequences of "portfolio insurance"
in 1987,
or, in the case of an individual company, the Tylenol tampering crisis at
Johnson & Johnson in 1983, uncertainty triumphs over reason, and
expectations change radically. On Wall Street, earnings projections become
meaningless, and neat predictions about the future prove unrealistic (they
almost always are anyway). Far from being rational, financial markets can
react violently at such times as they are pummeled by the fears of their
all-too-human participants. Securities prices, especially for equities,
usually suffer, as their valuations had become elevated during times of
stability.

Disruptions
are also characterized by extreme shortsightedness as participants seek to
preserve capital under fearful circumstances. "Efficiency"
becomes overwhelmed by emotion. For the investor, who by definition shuns
emotion and takes a long-term view concerning values, genuine "discounts" appear.
While markets may "abhor uncertainty," as the saying goes, investors love
the discontinuity that follows in its wake.

______________

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over
33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at
www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the
Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of
NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of
Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or
"What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at